China PMI, Bond Yields and the USD, RBA decision

China’s October PMI data surprised on the firm side and,although this strength has come with the support of seemingly unsustainable debt acceleration, ithas produced some inflationary pressures which are now expected to spill over into other economies. The Caixin report showed that input costs accelerated at their fastest pace since September 2011 and output charges rose by the greatest extent since February 2011. Rising input costs may have come via rising commodity prices. Coking coal has rallied 200% while iron ore prices have gained 60%.

Importantly, China is the biggest global exporter and the US purchases 22% of its total imports from China. Hence, rising inflation pressures in China will likely develop a global impact. The chart below illustrates how US inflation expectations have diverged from the performance of USD, presenting a new feature. This observation is most emphasised in the case of USDCNY. Previously,a rising USDCNY steered US inflation expectations lower, but when USDCNY rallied in October, US 5Y/5Y inflation expectations wenthigher and not lower. The once tight inverse relationship between the two broke. There are two explanations which in both cases should bode bearishly for bonds. First, the US may have closed its output gap (all eyes will on Friday’s wage release with the October NFP report), suggesting that USD-induced reductions of import prices no longer compensate for increasing domestic upward price dynamics. Second, China factory gate prices now rising at a faster pace (as indicated by the Caixin PMI report) are no longer compensated by the higher USDCNY.

Seeing nominal DM bond yields risinghas created an ideal environment for USD to rally against low-yielding currencies such as JPY. Importantly, the current USD rally has not yet found the support of higher US real rates and yields. Most of the recent yield lift-off has been driven by US inflation expectations, providing the current USD rally with an unusual feature, namely risk appetite staying relatively supported. Last year, it was falling risk appetite,asset volatility and its destabilising effect on cross border flows convincing the Fed to ease verbally, ultimately undermining the USD rally. Nowadays matters are very different. With US real rates and the term premium within the US bond market showing little movement, the risk outlook seems to remain supported for longer. Hence, the rising USD does not come with a significant tightening of US financial conditions, providing USD with additional space to rally.

The RBA left rates unchanged and projected the economy to “grow at close to its potential rate, before gradually strengthening. Inflation is expected to pick up gradually over the next two years”. AUD rallied, but in light of anticipated USD strength, we view current levels as providing strategic selling opportunities. Mining sector investment is expected to stay weak, leaving the labour market weak as the construction boom runs out of steam. Real estate is overvalued and while China, as Australia’s most important trading partner, is doing ok for now, we see its current unbalanced growth as unsustainable. Last butnot least, Australia’s inflation remains subdued. Hence, it will not take a lot to turn the RBA around once again, in our view.